Editorial: The fear of bank deleveraging

Bank Indonesia Governor Darmin Nasution has repeatedly assured the market that it is fully geared up to protect the financial services industry from any contagion from the lingering fiscal and financial crisis in the eurozone.

The incoming chief of the Financial Services Authority (OJK) Muliaman D. Hadad, who is now deputy governor of of the central bank, also asserted immediately after his selection by the House of Representatives on Tuesday that he would strengthen bank supervision to insulate the industry from any fallout from Europe’s crisis.

Of more importance is the fact that the central bank puts its money where its mouth is, as can be seen from its active intervention in the foreign exchange market, its decision to maintain its benchmark interest rate at 5.75 percent and its measures to replenish its foreign reserves by selling dollar-denominated term deposits.

It is indeed the financial market contagion from the euro crisis — not trade channels — that could adversely affect Indonesia’s economy in view of the likelihood of bank runs in the eurozone, especially after Moody’s Investment Services on Thursday downgraded by two to three notches 15 of the biggest global banks in Europe and the United States.

Even though the exposure of our banks to Europe through trade channels and money market was estimated by the central bank at only about US$16.5 billion, around a mere 5 percent of the banking industry’s assets, the monetary authorities should remain alert.

If the current financial distress worsens into a panic, it could trigger a massive withdrawal of Western lenders from emerging Asia, including Indonesia.

When capital is tight, banks usually focus on core markets, not the more challenging emerging markets such as Indonesia, and on core large clients, not small- and medium-scale borrowers, causing what economists call bank deleveraging.

Deleveraging takes place when lenders from developed countries systematically withdraw funding from emerging markets, either by naturally shrinking their asset bases by reducing loan rollover rates, or by selling equity stakes in local subsidiaries.

Western banks have been retrenching quietly, calling in loans or quietly withdrawing debt facilities or cross-border credit lines. Even the International Monetary Fund forecast in April that eurozone banks would shrink their balance sheets by $2 trillion over the next 18 months.

This is what has been happening in the eurozone where deepening economic contraction and rising bad loans have caused a credit crunch.

Its impact, though not as severe as the fallout from the global financial crisis which started in the United States in late 2008, has been hitting Indonesia, pressuring down the rupiah and share prices over the last few weeks.

Analysts predict deleveraging is likely to increase if the eurozone crisis isn’t sorted out as the strength of the balance sheets of parent banks is now being questioned.

Falling liquidity caused by deleveraging could hurt emerging stock markets, especially Indonesia’s, that depends mainly on external financing, and this would adversely affect capital-expenditure plans and slow economic growth.

But as we have often stressed in this column, our first line of defense against financial market instability is policy consistency and predictability, one of the keys to attracting direct investment.

Because unlike holdings in the stock market, bond or other money market instruments, which can be sold quickly when traders in Europe or US get jittery, direct investments in factories, companies and other fixed assets are harder to sell and are in the first place made and held for longer periods.